US short term interest rates

After a period of low interest rates, Central Banks around the would raised interest rates aggressively to contain inflation. The Federal Reserve led the way higher. In this post, we will examine the mechanics of how the central bank fixes interest rates and what are the main interest rates for short term investing.

The Federal Reserve has two main objectives: stable prices and maximum employment. The Federal Open Market Committee (FOMC) of the federal reserve sets the stance of the monetary policy that is believed to better deliver stable prices and maximum employment.

The monetary policy is then implemented mainly through the control of the Federal Funds rate

The Federal Funds rate is the interest that banks charge each other to borrow reserves in the federal funds market. Changes in the federal funds rate tend to drive changes in the level of interest rates that affect the cost of borrowing for businesses and consumers and the total amount of money and credit in the economy.

Commercial banks are legally required to maintain a minimum amount of their assets in the form of reserve accounts at the Central Bank. Banks have an account at the central bank that is used to meet their reserve requirements and to settle payments with other banks.

Monetary policy implementation before 2008

Before 2008, monetary policy was said to operate in a regime of reserve scarcity. This means that, since bank reserves earned no interests, banks tended to hold just a bit more of what was needed to meet their reserve requirement. In this regime the FED controlled interest rates by adjusting the level of reserves in the banking system using what is called open market operations.

In the FED wanted to lower FED Funds rates it would buy government securities on the open market. The Fed paid for the securities by electronically crediting the reserve accounts of the banks that sold the securities. In this way, the increase in the supply of reserves put downward pressure on the federal funds rate.

On the contrary, if the FED wanted to raise FED funds rate it would sell government securities, collecting payments from banks by withdrawing funds from their reserve accounts. The resulting   reduction in the supply of reserves put upward pressure on the federal funds rate.

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Monetary policy implementation post 2008

Post 2008 the situation has completely changed as we switched to a system of “ample” reserves. During the quantitative programmes, the FED bought in fact a large amount of government and mortgage securities from banks. As always, the central bank paid for these securities by electronically crediting the reserve accounts of the banks. This activity increased enormously the level of reserves (now a few trillion vs around 30 billion before 2008). Open market operations were not sufficient anymore to control the price of reserves and the FED started to use other tools.

So how does the FED implement its monetary policy decisions in terms of level of interest rates?

First of all, the Federal reserve decides a range within which it wants to keep the Federal Funds rate

At the time of writing the range is 3.75% – 4.00%. So how does the FED keep the FFR (Fed Funds rate) is it kept within this range? To keep the FFR within the range the FED utilize two so called administered rates.

First of all, there is a rate, called IORB (Interest on Reserve Balances) that is the rate that the FED pays on bank reserves (both required reserves and excess reserves). If you think about it, banks are very unlikely to lend reserves in the federal funds market at rates that are below this rate because they can get the IORB rate from the FED that is basically investing risk-free.

Now this rate is at 3.90%. This is the lowest level at which banks are willing to accept lending out their funds.

The problem is that not all financial institutions are allowed to have an account at the FED on which they can get the 3.90% IORB rate. This leaves the possibility that they might be willing to lend below this level and short-term rates could fall below the IORB.

That is why, in 2014, the FED created the Overnight Reverse Repo Facility (ON RRP facility). This is a facility in which non-banks, such as money market funds for example, that are not allowed to keep an account at the FED, can deposit money overnight at the FED. Basically these non-banks buy securities from the FED (investing money) with the accord of selling back the day after (getting the money back) and getting a certain rate which is the ON RRP rate. So being able to invest risk-free at the FED at the ON RRP rate, even non-banks that do not have an account at the FED will ever lend money below ON RRP rate.

This rate is currently at 3.80%.

Above these rates there is the Discount rate that is the rate at which the FED lends at banks if they are unable to borrow. Borrowing from the FED at the discount window is anyway perceived as a stigma because it shows that other private sources are not available and banks prefer not to do it.

Fed discount rate is currently at 4%.

On the basis of the above mechanism, the so-called Effective Funds rate, meaning the median of the overnight FED FUNDS transactions, is currently kept at 3.83%.

As we said at the beginning, by controlling the level of FED Funds, the central bank is able to control the level of all other interest rates. The influence is anyway stronger on short maturities, while long term ones are more driven by expectations on inflation and economic growth.

Below, we mention some of the main short term interest rates.

SOFR – The Secured Overnight Financing Rate (SOFR) represents the cost of borrowing funds overnight using Treasury Securities as a collateral. At the time of writing the SOFR is 3.80%.

For maturities longer than one day, a series of deposit rates is calculated that indicate the annualized rate at which banks would lend of borrow over a specified maturity. For example, interest rates now are around 4.15% (mid) for borrowing and lending with no collateral as a guarantee and around 3.82% for borrowing and lending with collateral.

Also, short term Treasury bills exist. If a financial institution wants to invest in a treasury bill it will probably get a lower rate that if it lended money to another financial institution as treasury bonds are vitually risk free. For example, investing now at 1 month in treasury Bills returns a yield of 3.76%.

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